For the past 20 years or more I’ve seen convertible notes as the best instrument for founders taking on a seed investment. Selling equity when you are a very early stage startup is very difficult for one simple reason: it’s impossible to set a valuation that is fair for both the entrepreneur and the investor. It’s a zero sum game: investors want more equity for their dollars and founders want more dollars for their equity. And there is only 100% equity to incentivize not only founders but future executives and staff. Trying to predict the future value of an early stage company can become an exercise in frustration.
So you might say, why not just get a loan? But banks and any other financial institutions want one important thing for a loan: collateral. Collateral is something of value – your house, your car – that they can repossess if you default on your loan. But banks aren’t about to repossess your code or your prototype – neither has value to them. Thus comes the convertible note, which is a type of debt that makes sense for both the early stage investor. i.e. angels, and the founder, and it has been the standard for years.
There are two key features to a convertible note, the discount and the valuation cap. The discount rewards early investors for taking on larger risks than later investors by offering them the right to obtain shares at a cheaper price than that paid by Series A investors once the Series A round closes. So if Series A investors pay $1.00 per share, holders of convertible notes – and a startup may have several – get to convert their loan amount at typically a 20% discount, thus enabling them to buy shares for not $1.00 per share but 80 cents. The market tends to set the typical discount rate, thus eliminating a lot of negotiation and frustration between founder and investor.
The valuation cap sets the maximum value of a company when the Series A closes. Again that provides a benefit to the holders of the convertible note as the know in advance the minimum number of shares their loan will convert to. In other words they know the worst case scenario in advance. Setting the cap, however, can be more contentious than the discount rate. Just like ordinary loans, convertible debt contain an issuance date, an interest rate, and a maturity date. But repayment is made with equity – or not made at all if the company goes belly up before raising a Series A. The investor has the option of choosing between the lower of either the discount or the cap conversion. The conversion price that’s the lower of the two methods results in more shares issued to the early investor upon conversion.
So what the heck is SAFE and why was it invented? SAFE is an acronym that stands for “simple agreement for future equity” and was created by the Silicon Valley
accelerator Y Combinator as a new financial instrument to simplify seed investment. Here are the key variables and how SAFE differs from convertible notes which I have taken from Melissa Hollis’s article
1. SAFE Offers Simplicity by Minimizing Terms
One problem with convertible notes is that they have a lot of moving parts. And every lawyer likes to write his own version – similar to NDAs – there is no industry standard convertible note. SAFE simplifies things by eliminating two moving parts: the interest rate and the maturity date (these are hangover variables from typical bank loans).
2. Different Points of Conversion to Equity
There are two different points when it comes to triggering conversion of the loan to equity. A convertible note can allow for the conversion into the current round of stock or a future financing event, a SAFE only allows for a conversion into the next round of financing. So again, SAFE is simpler.
SAFE converts only when you raise any amount of equity investment unlike convertible notes which trigger only when a “qualifying transaction takes place” (more than a minimum amount dictated on the agreement) or when both parties agree on the conversion.
Finally raising common stock doesn’t trigger a conversion for a SAFE investor (keep in mind that VCs always invest in preferred stock, with its preferences over common stock).
3. The Valuation Cap
Typically convertible notes come with a valuation cap and SAFE may not. But as above, this is the sticky negotiating term with either convertible notes or SAFE. However, by foregoing a valuation cap you could be diluting your shares and your future investors’ shares when you go to raise your Series A.
4. Early exits
What happens if the company is sold before raising a Series A? Both convertible note and SAFE investors give the investor a return. SAFE gives the investor the choice of a 1x payout or conversion into equity at the cap amount to participate in the buyout. Obviously who the acquiring company is and the state of their stock will decide which route the investor takes. Convertible notes typically have a 2x payout. Here’s a case where the convertible note is actually simpler than a SAFE, but may make it less attractive to the investor.
5. SAFEs have no interest rate
SAFES are not debt, they are defined as a warrant. A warrant gives the investor the right, but not the obligation, to buy shares at a certain price before expiration. Convertible notes are loans, and as such carry an interest rate, which in my experience generally runs about 8%. Again SAFE has fewer moving parts, meaning fewer elements have to be negotiated, providing a simpler instrument with an advantage for the founder.
6. Maturity date
If you have been paying attention to this point you know that SAFE is not a debt instrument so it doesn’t have a maturity date. Convertible notes do. So what happens when you reach the maturity date of a convertible note? You either have to pay back the principle plus interest – just like a normal loan or you convert the debt into equity. If you are running out of money you certainly can’t afford to pay back your note! So SAFE is a lot safer in this regard. I’ve yet to hear of a company that paid back its convertible note!
7. Administration Fees and Services
Typically neither a SAFE nor a convertible note comes with any admin fees or need for professional services, e.g. legal or accounting, although theoretically a SAFE could trigger the need for a fair (409a) valuation to formalize your company’s common stock value.
The bottomline is that SAFE is simpler, with fewer moving parts and thus less chance of getting into a fractious negotiation with your investor. The best way to determine which instrument is best for you, however, is to work through the decision trees for both options and create cap tables on a Series A for both options. Like any decision, scenario planning is usually the most effective means of decision making. That means translating legalese into practical business consequences. Get used to it, that skill will often be needed by any startup that grows successfully.
Being neither a lawyer nor an accountant I can’t give you a qualified opinion on which is best for the founder. Offhand one would think that an instrument created by an investing company, i.e. Y-Combinator would favor the investor. But I believe the reason that Y-Combinator created the SAFE is that at the extraordinarily high volume of startups it invests in the efficiencies of simplicity of SAFE outweigh the small advantages to the founder.